How Financially Sound Must Leaders Be?

Would you be happy knowing that the leader of a corporation you just bought stock in has recently filed for personal bankruptcy. Would that affect your evaluation of the solvency and future of the company itself, or perhaps raise questions regarding the quality of the governance of the company?

In theory, personal finances and company finances are a completely separate domain. With publicly listed companies – a directors own funds will never be used to finance the company (director loans are only common in small, unlisted business) and thus the success of the business will never depend on the financial stability of the executive himself.

Of course, theory does not always play out true, and a theoretical separation between leadership and finance does not mean that there will not be a link in appearance. At the heart of this question is the area of trust. Rather than looking at the cold hard facts (such as ‘has the CEO managed the company sensibly?) we would let personal financial struggles affect our trust in the leader. Once the trust is gone, shareholder sentiment will nosedive and rumours will begin to circle that leading institutional investors are not satisfied with the ‘stewardship’ ability of the manager, and this could lead to a vote of no confidence or an outright eviction from the board itself.

Example of such bankruptcies are rare, and are usually caused by the leaders other financial interests taking a nose dive (e.g. large losses on development of condos). But there is one key reason why personal finances and corporate finances are inexorably linked: management incentive schemes.

Management incentive schemes allow leaders to earn rewards for taking risks and increasing earnings at the business. However if the leader is approaching bankruptcy – they have nothing to lose and everything to gain from taking excessive risks in the hope of a big payoff, in the knowledge that bankruptcy would wipe all their debts anyway. So there is certainly reason for concern.

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